Dangerous currents

An email I sent a friend this morning after another 1000 point correction in the Dow-Jones Industrial Average Index:

With the second day of 1000 point correction in the Dow-Jones Industrial Average, investors are prone to become nervous.

The S&P was down 2.8% on Thursday (Feb. 8) and the DJIA index was down 4+%.

Economic fundamentals in the United States and elsewhere may not have so dramatically changed in the last two weeks to warrant ‘panic selling’ in stocks.

If anything, Atlanta Federal Reserve began its first quarter 2018 ‘nowcast’ real GDP growth estimate at 5% (QoQ, annualised). For the world too, the International Monetary Fund had recently upgraded its assessment of global growth. Of course, they were optimistic on the world economy in April 2007 too. Never mind.

But, to take recourse to economic fundamentals and cite it as a reason (or, excuse) to buy stocks is flawed because we do not usually recommend investors to sell when fundamentals do not support big gains in stock markets as is often the case.

When stocks rise due to generous liquidity and low interest rates (zero or even negative, as in this cycle) and when fundamentals remain stuck in the cellar, we do not advise investors that stock markets are unhinged literally and otherwise.

We reassure ourselves and investors that liquidity considerations dominate fundamentals. Hence, now, we cannot fall back on fundamentals to justify buying at this stage. It is unreasonable and asymmetric.

If economic fundamentals are strong, then it means that the Federal Reserve faces no constraint to raise interest rates more aggressively than what the market expects. Recall the urgent announcement of a more aggressive monetary policy tightening this year by the Bank of England on Thursday. They were quite reluctant to recognise that the Bank of England monetary policy was hopelessly ‘behind the curve’ with respect to the inflation in goods and services and in asset prices.

If the economic fundamentals are weak or have become weaker, then yes, the Federal Reserve may not tighten much. But, is that now a good thing? What happens to assumptions of double-digit growth in Earnings Per Share for S&P 500 in 2018 and 2019? Will they be justified too, still, if fundamentals are weak? Again, will we resort to the liquidity argument to justify being long in the market?

The disconnect between earnings and stock prices remains strong and lasts for a long time, until it does not. At some point, they bite and matter for stocks.

So, the short point is that investors cannot have it both ways.

Should the Federal Reserve go weak-kneed and abort tightening, there could be violent rallies for a short while. But, the dollar will fall heavily and other countries may not be  in a position to take it. The global economic cycle is both fragile – unlike what IMF thinks – and is already long in the tooth.

The mindless exuberance of the last few years fuelled by (yet again) monetary policy mistakes and investor complacency, induced by it.

There may be short-term swift rallies in between. One can look back and realise that global stocks had so many such rallies in 2008 too.

Investors are now beginning to realise that the Federal Reserve is either going to be aggressive or it is too behind the curve. Or, it is both. Both are not favourable for stocks.

Caveat Emptor! This is no an investment recommendation, by the way.

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